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Oil prices, poor countries and policy responses

16 March 2011

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16 March 2011

The recent turmoil in the Middle East and North Africa has pushed the price for a barrel of Brent crude oil to $115, an increase of more than 40% on last year’s average of $79.6. UK Development Minister Alan Duncan suggests the unrest could double current oil prices to more than $200 a barrel.

ODI has mapped out the potential impact of rising oil prices on GDP, and what this could mean for the poorest countries, and the poorest people within them. High and volatile oil prices are an incentive to support growth strategies which are less vulnerable to oil price volatility and more resilient against crises.

The combination of the Iranian revolution and the Iraq/Iran War more than doubled crude oil prices from $14 per barrel in 1978 to $35 in 1981. Thirty years later, Iran's production is only two-thirds of that achieved under the Shah.

When Iraq invaded Kuwait in 1991, oil cost $21 per barrel. Five months later, it peaked at $44. The average price during the conflict increased to $28, a one-third increase.

Before the 2002-2003 Iraq war, the price of oil had fallen to around $17 per barrel – thanks to slow economic growth following the 9/11 terrorist attacks. But it rose by 40% to $26 per barrel during the war in Afghanistan.

Libya’s current oil production of 1.6 million barrels a day is already at risk. The World Bank’s Global Economic Prospects 2006 simulated the disruption of an oil supply of 2 million barrels per day, resulting in a rise in oil prices of one-third in the first year. Given the current turmoil, an oil price rise of 33-40% looks increasingly realistic.

Impact on developing (oil importing) countries

We have reviewed the likely impact of a one-third increase in oil prices over two years. The evidence suggests that it would lead to a 1% reduction in global GDP – a loss of some $500 billion from a world economy still recovering from the financial and economic crisis. GDP in sub–Saharan Africa – the world’s poorest region – would also fall by 1%, worth some $8 billion. The reduction in world GDP is because a higher oil price transfers money from countries with a higher propensity to spend to countries with a lower propensity to spend. Further reductions in investment and incomes can take place with significant oil price volatility and contagion on financial markets. The World Bank has suggested that the recent increase in oil price of $20 would lower developing country GDP by around 0.2-0.4%.

The poorer the oil importing country, the greater the problems. Poorer countries tend to use more oil to achieve the same output and tend to have more constraints on their current accounts.

The study suggests that some of the poorest countries could lose up to 4% of their GDP. Those likely to lose more than 3% of GDP as a result of a one-third increase in oil prices include Ghana, Honduras, Lesotho, Swaziland, Togo, Moldova and Nicaragua. Those likely to lose more than 1% of GDP include Burkina Faso, Burundi, Ethiopia, Malawi, Mali, Mozambique, Nepal and Niger. This is assuming that there are no market or policy interventions.

At national level, government balances could worsen in countries where oil prices are controlled, and changes in oil price structures may lead to protests as seen in Indonesia (1998), Nigeria (2000) and Yemen (2005). For example, there are already question marks surrounding the affordability of oil price subsidies in Thailand, where oil products constitute around 10% of the consumer basket. Fortunately, the fiscal position in some developing countries that have been growing is fine, but this certainly not the case for others that have seen the fiscal balances worsen due to a number of shocks.

At the household level our review of the evidence finds that both rich and poor households suffer as a result of oil price increases, but the poor tend to suffer more. There are direct effects, with the poor spending a large share of their small incomes on oil and oil products. In Ghana, Guatemala, India, Nepal, South Africa and Vietnam, the poorest households may spend as much as 3-4% of their income on kerosene, compared to little more than 1% of the richest households. There are also indirect effects, with rising transport costs affecting the poor more than the rich.

The evidence suggests that rising oil prices and falling GDP have a direct impact on the most vulnerable people. A drop of 1% in African GDP could increase the number of infant deaths by 5,000 each year, and child deaths by around 10,000. In countries that are more sensitive to falling incomes the impact could be worse.

The analysis shows that some of the poorest countries such as Mauritania, Moldova, Nicaragua, Sierra Leone and Togo are at risk amongst the most oil vulnerable economies, but other countries such as Bangladesh, Kenya, Rwanda and Zambia are also at risk.

Global policy responses

Oil price shocks need a three pronged policy response:

Terms of trade shocks can hit poor countries hard. The international community has international shock facilities to help them, such as the European Commission’s V-FLEX, the IDA crisis facility, or support from the IMF in the case of Balance of Payment shocks. Given that the world has faced so many shocks in recent years, these facilities need continuous review. The IDA crisis facility has recently been negotiated, but the future of the EC’s shock facilities will be discussed as part of the new financial perspectives over 2014-2020.

The global financial crisis has taught us that ‘vulnerability equals exposure minus resilience’. So promoting resilience seems a sensible strategy to deal with crises. This includes promoting not only fiscal space, but also economic and social governance such as effective natural resource rents, good state-business relations and growth-enhancing social programmes. Measures to build resilience need to be built firmly into the G-20 pillars for growth and growth strategies in countries that are highly vulnerable to oil prices rises and other shocks that threaten the well-being of their people.